Conversable Economist

As computers became widespread in the 1980s and into the early 1990s, a common prediction was that we were headed for the \”paperless office.\” But that prediction went badly astray, as Abigail Sellen and Richard Harper pointed out in their 2002 book, The Myth of the Paperless Office.
For example, they cited evidence that consumption of common office paper rose by 14.7% from  1995 and 2000  and they argued that that when organizations started using e-mail, their consumption of paper rose by 40%. In short, it appeared that information technology was not a substitute for the use of paper, but instead was a complement for it–in other words, computerization was going to be the best thing that ever happened to the paper industry.

But although the transition took some time, it now appears that at least U.S. offices are becoming, if not quite paperless, much less paper-intensive. Here\’s a figure from the Environmental Paper Network\’s State of the Paper Industry 2011, which came out last year. Notice in particular the decline in paper use since about 2007 in North America and Western Europe.

The report describes U.S. paper consumption trends in this way (notes omitted):

\”Consumption of paper and paperboard products has experienced significant decline in North America since 2007. This is attributable primarily to the aftermath of the financial crisis in the United States at the end of the decade. The poor economy motivated many companies to perform a close analysis of their paper use and inspired the adoption of innovative and more efficient systems. These new systems will remain in place into the economic recovery and likely have a lasting impact on printing and writing paper consumption. In addition, the shift in the patterns of consumption of news and other media from print to digital formats is also apparently having an irreversible effect in
some paper sectors such as newsprint.

\”Total global consumption of paper is still rising, reaching 371 million tonnes in 2009. However, total paper consumption in North America has declined 24% between 2006 and 2009. Per capita consumption of paper in North America dropped from more than 652 lbs/year in 2005 to 504 lbs/year in 2009.

\”North Americans still, however, consume almost 30 times more paper per capita than the average person in Africa and 6 times more than the average person in Asia. In 2009, total paper consumption in China eclipsed total North American consumption for the first time.\”

I remember stories from the old days of computerized offices, maybe 15-20 years ago, about executives who wanted all their e-mails and reports printed out. Those days are gone. But it\’s interesting to me that even for a change that seems as obvious as electronic communication leading to less paper, it took some years and the pressures of a recession for substantial change to take effect. Similarly, it wasn\’t until about 2006 that the volume of mail carried by the U.S. Postal Service took a nosedive. All the consequences of major technological changes can take decades to ripple through an economy.

When I chat with people about China\’s economic growth, I often hear a story that goes like this: The main driver\’s behind China\’s growth is that it uses a combination of cheap labor and an undervalued exchange rate to create huge trade surpluses. The most recent issue of my own Journal of Economic Perspectives includes a five-paper symposium on China\’s growth, and they make a compelling case that this received wisdom about China\’s growth is more wrong than right.

For example, start with the claim that China\’s economic growth has been driven by huge trade surpluses. China\’s major economic reforms started around 1978, and rapid growth took off not long after that. But China\’s balance of trade was essentially in balance until the early 2000s, and only then did it take off. Here\’s a figure generated using the ever-useful FRED website from the St. Louis Fed.

How does China\’s pattern of trade balances line up with argument about China\’s undervalued exchange rate? Here\’s a graph showing China\’s exchange rate over time in yuan/dollar. Thus, an upward movement on the graph means that yuan is weaker relative to the dollar, and a downward movement means that it is stronger relative to the dollar. The yuan does indeed get weaker relative to the U.S. dollar for much of the 1980s and first half of the 1990s–but this is the time period when China\’s trade balance is near-zero. China\’s exchange rate is pretty much unchanging for the five years or so before China\’s trade surplus takes off. Since 2006, the yuan has indeed been strengthening. Last week the yuan hit a record high against the dollar since 1994.

What about China\’s purportedly cheap wages? Here\’s a figure from the article by Hongbin Li, Lei Li, Binzhen Wu, and Yanyan Xiong, called \”The End of Cheap Chinese Labor.\” As the figure points out, China\’s wages were fairly during much of the 1980 and 1990s, which is the time when China\’s trade was nearly in-balance. But whether the conversion is done using yuan/dollar exchange rates or by inflation in China (measured by the producer price index), wages in China have been rising at double-digit annual rates since the late 1990s. In other words, China\’s big trade surpluses of the last decade have co-existed with sharply rising wages.

Clearly, China\’s pattern of economic growth since the start of its reforms needs a different storyline than the basic tale of low wages, a cheap currency, and big trade surpluses. After working with these authors, my own view is that it\’s useful to think of China\’s economy since about 1978 in two main stages–although there isn\’t a clean-and-clear break between them.

The first stage of China\’s growth that went through the 1980s and a bit into the early 1990s was really about rural areas.  Yasheng Huang makes this argument strongly in his JEP article \”How Did China Take Off?\” Huang writes: \”China’s take-off in economic growth starting in the late 1970s and its poverty reduction for the next couple of decades was completely a function of its rural developments and its internal reforms in general. During the golden era of rural industry in the 1980s, China had none of what are often thought of as the requisite features of the China growth model, like massive state-controlled infrastructural investments and mercantilism.\” This was the time period when the agricultural sector was allowed to operate under a market framework, and as agricultural output exploded, rural workers moved to employment in the \”township and village enterprises.\” Huang makes a strong argument that these enterprises should be thought of a privately owned firms, operating with what was in many ways a private-sector financial market.

But in the 1990s, the emphasis of China\’s economy began to change. New leaders favored urban development over rural development, and they cut the township and village enterprises down to size by re-nationalizing their sources of finance They began to reform the money-losing state-owned enterprises that still dominated China\’s urban economy as of the early 1990s. They moved China toward joining the World Trade Organization, which happened in 2001. For a sense of the transition in China\’s urban areas to private sector employment, here\’s another useful figure from Li, Li, Wu and Xiong:

But this process of change brought an unexpected macroeconomic imbalance. As Dennis Tao Yang point out in his JEP paper, \”Aggregate Savings and External Imbalances in China,\” China\’s 11th Five-Year Plan for the years from 2006-2010 called for trade to be in balance overall–clearly an expectation that was not close to being met. Yang looks at a variety of reasons why savings rates took off in China: for example, after China joined the WTO in 2001, exports took off, but firms lacked useful ways in China\’s underdeveloped financial system to pass these savings to the household sector; as exports took off, China\’s government received an unexpectedly huge surplus, with budget surpluses upward of 8% of GDP; and households, concerned about retirement and health costs for themselves and their families, and with little access to loans for mortgages or consumer durables, continued to save at very high rates. Yang notes that in China, this combination of outcomes is sometimes criticized as the \”Nation Rich, People Poor\” policy.

Thus, although China\’s economy continues to grow rapidly, it is faced with many challenges. Along with the macroeconomic imbalances emphasized by Yang, Xin Meng raises another cluster of issues in her paper, \”Labor Market Outcomes and Reforms in China\”: the extraordinary back-and-forth migration from rural to urban areas, now at well over 100 million people per year, and perhaps headed much higher; the growing inequalities in wages as labor markets move away from the administratively determined wages that were so common even just 20 years ago; the inequalities being created by the spread of education; and China\’s coming demographic bulge with many elderly and few young workers–a hangover of the one-child rules to limit population growth.

With little effort, one can compile quite a list of economic difficulties facing China: macroeconomic imbalances, an underdeveloped financial sector, inequalities in wages and across rural and urban areas, the demographic bulge, corruption, environmental problems, and more. Still, with all that said, it\’s worth remembering that China\’s economy still has enormous potential upside. China started from such a low per capita GDP back in 1978 that even now, productivity levels are only about 20% of the U.S. level. In yet another JEP paper, \”Understanding China’s Growth: Past, Present, and Future,\” Xiaodong Zhu points out that when Japan and Korea and Taiwan had their rapid spurts of economic growth int he 1950s and 1960s and 1970s, they were essentially raising their productivity levels from 40-50% of the U.S. level up to 70-80% of the U.S. level. In other words, China is still far below the level that was the take-off point of rapid growth for countries like Japan, Korea and Taiwan. As Zhu points out, China is making enormous investments in education, physical capital investment, and research and development. In many ways, it is laying a framework for continued growth.

Surely, many things could go wrong for China\’s economy. For continued growth, it will need to transform its economy again and again. But it also seems to me that hundreds of millions of people in China have developed a sense of possibility, and of what their economic lives could hold for them. China\’s future growth is sure to have fits and starts, like every country, but its economy continues ot have enormous momentum toward a much higher standard of living.

There\’s always a lot of talk about how marginal tax rates affect the incentives of those with high incomes. But how high are marginal tax rates on those with low incomes? The question might seem peculiar. After all, don\’t we know for a fact that those in the bottom of the income distribution, at least on average, don\’t pay federal taxes? Instead, on average, they get \”refundable\” tax credits from the federal government for programs like the Earned Income Tax Credit and the child credit. As a result, the Congressional Budget Office has calculated that the bottom two quintiles of the income distribution pay a negative income rate. Even with payroll taxes for Social Security and Medicare and federal excise taxes on gasoline, cigarettes and alcohol added in the bottom quintile of the income distribution pays only 1% of its income in federal taxes.

But the marginal tax rate that someone owes is not the same as the average tax rate that they owe. Those with low incomes can often face a situation where, as their income rises, the amount that the receive from the Earned Income Tax Credit declines. There are other non-tax programs like Food Stamps, Medicaid, Temporary Assistance to Needy Families (welfare), and Children\’s Health Insurance Program (CHIP) that phase out as income increases. Thus, for each marginal $1 that someone with a low income earns, the gradual withdrawal of these benefits means that their after-tax income rises by less than $1. In addition, even those with low incomes pay Social Security and Medicare payroll taxes.

The Congressional Budget Office has taken on the tax of calculating \”Effective Marginal Tax Rates for Low- and Moderate-Income Workers.\”  Here\’s an illustrative figure showing before-tax and after-tax income for a hypothetical single parent with one child. Before-tax income is just a straight line for illustrative purposes. The line for after-tax income shows what after-tax income would be for this family, given the before-tax level of income. For example, with a before-tax income of zero, after tax income would be approximately $20,000, due to various transfer payments. At a before-tax income of about $27,000, after-tax income is also about $27,000: that is, $27,000 is the break-even point where the subsidies available from the government at that income level are equal to the taxes being paid at that income level. In general, the after-tax income line has a flatter slope that the before-tax line, which is telling you that when you earn $1 of before-tax income, the gain to after-tax income is less than $1–even for those with low and moderate income levels.

The first graph is more-or-less real data, but for a hypothetical family. A second graph looks at the actual marginal tax rates by household income level. At any given income level, of course, there is actually a range of marginal tax rates, depending on how many people are in the family, what programs they are eligible for, even state they live in (because benefit levels for many programs will vary by state). Thus, there will be a range of different marginal tax rates for households at any given income level. The graph shows the range of marginal tax rates for any given income level, ranging from the 10th percentile of marginal tax rates up to the 90th percentile. Earnings on the horizontal axis are shown as a percentage of the federal poverty line (FPL).

Two main patterns jump out at me from this graph. One pattern is that there is an enormous range of marginal tax rates at very low income levels, at and below the poverty line. This range of marginal tax rates reflects the enormous diversity in types of households in poverty, and what sort of government assistance each family is eligible for. The other pattern is that for those from about 200% of the poverty line up to about 600% of the poverty line, a sizeable proportion of households are facing marginal tax rates–considering federal income and payroll taxes, along with food stamps–in the range of 30-40%.

These high marginal tax rates on those with low and moderate levels of income raise some questions for those on all sides of the tax debates. For those who don\’t believe that high marginal tax rates have much affect on incentives to work at higher income levels, like households earning $250,000 or more per year, consistency would seem to suggest that they shouldn\’t worry too much about incentives to work at lower income levels, either. For those who express a lot of concern about how high marginal tax rates would injure incentives to work for those at the top income levels, consistency would seem to suggest that they express similar concern over lower marginal tax rates for those at the lower and moderate income levels, too–which means making programs like the Earned Income Tax Credit, food stamps, welfare, and others more generous, so that they can be phased down more slowly as people earn income.  

Advertising may be that rare case where economists are less cynical than the general public. For many people, advertising is the epitome of exploitative and wasteful capitalism, encouraging people to feel bad unless they spend money they don\’t have for goods and services they don\’t actually want or need. Many business firms spend their advertising dollars ruefully,while quoting the old line: \”I know that half of the money I spending on advertising is wasted, but the problem is that I don\’t know which half.\” 

 But while many see this glass as totally empty, economist see it as half-full. Yes, advertising can be a arms-war of expenditures that benefits no one, while creating consumer dissatisfaction. But it can also be a form of active competition leading to lower prices and better products for consumers. Here, I\’ll give a few facts about advertising, review the classic arguments from back in Alfred Marshall\’s 1919 classic Industry and Trade, and point out a bit of recent evidence that consumers may well benefit from lower prices when advertising expands.

  Kantar Media reports that total U.S. advertising spending was $144 billion in 2011–which is about 1% of GDP. That money is pretty well spread out across advertisers and across different kinds of media: for example, the top 10 advertisers account for only a bit more that 10% of total advertising spending.

At the global level, according to Nielson\’s Global AdView Pulse Report, advertising totalled almost $500 billion in 2011.

 

The great economist Alfred Marshall laid out the social pros and cons of advertising in his 1919 book, Industry and Trade. On one side, he emphasizes the role of advertising in providing information and building reputations, names, and trademarks; on the other hand, he points out that it can be carried to excess. Here are a few of Marshall\’s comments. Even a century ago, he was skeptical about how American advertising, in particular, was often being carried to excess.  

 \”The reputation acquired by large general advertising is easy of attainment, though expensive. It is indeed seldom of much value, unless accompanied by capable and honourable dealing: but, when attained, it extends in varying degrees to all products made or handled by the business: a name or a trade mark which has gained good fame in regard to one product is a great aid to the marketing of others.\” (p. 180)

\”On the other hand, some sorts of private retail trade are spending lavishly on competitive advertisements, most of which waste much of their force in neutralizing the force of rivals. In America, where they have been developed with more energy and inventive force than anywhere else …\” (p. 195)

\”Some of the implements of constructive advertisement are prominent in all large cities.  For instance a good frontage on a leading thoroughfare; adequate space for the convenience of employees and for customers; lifts and moving staircases, etc., are all constructive, so long as they do not exceed the requirements of the business. That is to say, the assistance, which they afford to customers by enabling them to satisfy their wants without inordinate fatigue or loss of time, would be appropriate, even if the business were not in strong rivalry with others. But eager rivalry often causes them to be carried to an excess, which involves social waste; and ultimately tends to raise the charges which the public have to meet without adequate return.\” (p. 200)

\”On the other hand the combative force of mere capital obtrudes itself in the incessant  iteration of the name of a product, coupled perhaps with a claim that it is of excellent quality. Of course no amount of expenditure on advertising will enable any thing, which the customers can fairly test for themselves by experience (this condition excludes medicines which claim to be appropriate to subtle diseases, etc.), to get a permanent hold on the people, unless it is fairly good relatively to its price. The chief influence of such advertisement is exerted, not through the reason, but through the blind force of habit: people in general are, for good and for evil, inclined to prefer that which is familiar to that which is not.\” (p. 194)

\”In conclusion it should be noted that academic students and professional advertising agents in America have united in applying modern methods of systematic and progressive analysis, observation, experiment, record, and provisional conclusion, in successive cycles to ascertaining the most effective forms of appeal. Psychology has been pressed into the service: the influence which repetition of an advertisement exerts has been subsumed as a special instance of the educative effect of repetition.\” (p. 201)

\”I first show that the taxation of advertising is indeed a powerful instrument to restrict advertising expenditures of firms. I also show that advertising increased consumer prices in some industries such as alcohol, tobacco and transportation, in which the persuasive effect dominates. But it also decreased consumer prices in other industries such as food. I use data from existing marketing studies which make it possible to relate different responses of market prices to characteristics of advertisements in industries. I can indeed show that those industries which exhibit the informative price include more information in their advertisements, consistent with the interpretation of informational and persuasive forces of advertising.

\”The aggregate effect is informative, which means that, on average, advertising decreases consumer prices. This suggests that the Austrian advertising tax increases consumer prices and probably affects welfare adversely. I estimate that if the current 5% tax on advertising in Austria were abolished, consumer prices would decrease by about 0.25 percentage points on average.\”

Ernst and Young has produced an interesting report called: \”University of the Future: A thousand year old industry on the cusp of profound change.\” Although the report is aimed specifically at Australian universities, many of the insights apply all around the world. The tone of the report is summed up right at the start:

\”Our primary hypothesis is that the dominant university model in Australia — a broad-based teaching and research institution, supported by a large asset base and a large, predominantly in-house back office — will prove unviable in all but a few cases over the next 10-15 years. At a minimum, incumbent universities will need to significantly streamline their operations and asset base, at the same time as incorporating new teaching and learning delivery mechanisms, a diffusion of channels to market, and stakeholder expectations for increased impact. At its extreme, private universities and possibly some incumbent public universities will create new products and markets that merge parts of the education sector with other sectors, such as media, technology, innovation, and venture capital.\”

Tertiary education is on the rise all around the world. This figure shows participation rates for 18-22 year-olds in tertiary education around the world. Just from 2000 to 2010, the percentage has tripled in China, and more-or-less doubled in India, East Asia and the Pacific, and Latin America. (Side note: \”MENA\” in the table refers to the \”Middle East and North Africa region.)

Finishing a four-year college degree is historically something that happens for well under half of students in high-income countries, and for only a tiny slice of students in low-income countries. With the dramatic expansion of attendance, the traditional model won\’t work well–it\’s just too costly on a per-student basis. How this industry will shake out in world of digital technology and global mobility, along with research programs that are increasingly intertwined with industry, is not at all clear. But the E&Y report offers a glimpse of some of the possibilities. Here are a few thoughts, scattered through the report, that jumped out at me.

\”The likely outcome over the next 10-15 years is the emergence of a small number of elite, truly global university ‘brands’. These global brands of the future will include some of the ‘usual suspects’ — a subset of Ivy League and Oxbridge institutions — as well as a number of elite institutions from China.\”

\”The relationship between industry and the higher education sector is changing and deepening. Industry plays multiple roles: as customer and partner of higher education institutions and, increasingly, as a competitor. … Research commercialisation will go from being a fringe activity to being a core source of funding for many universities’ research programs. …  Finally, industry will increasingly compete with universities in a number of specialist professional programs. Accounting industry bodies already provide a range of specialised postgraduate programs (CPA, CA, CFA etc). Other industry groups, for example engineering associations and pharmacy guilds, may play an increased role as certifiers and deliverers of content.\”

\”Organisations in other knowledge-based industries, such as professional services firms, typically operate with ratios of support staff to front-line staff of 0.3 to 0.5. That is, 2-3 times as many front-line staff as support staff. Universities may not reach these ratios in 10-15 years, but given the ‘hot breath’ of market forces and declining government funding, education institutions are unlikely to survive with ratios of 1.3, 1.4, 1.5 and beyond.\”

\”Use of assets is also an area with scope for much greater efficiency. Most universities own and maintain a sizeable asset base, much of which is used only for four days per week over two 13-week semesters — not much more than 100 days per year.\”

\”Incumbent public universities bring two critical assets to this model: credibility and academic capability. In an age of ubiquitous content, ‘content is king’ no longer applies. Credibility is king — and increasingly ‘curation is king’. Universities are uniquely positioned to bring credibility and to act as curators of content. The challenge for public universities in this world is to cut the right deal — a deal that builds in brand protection and a reasonable share of the value created.\” 

One university vice-chancellor is quoted as saying: \”Our major competitor in ten years time will be Google … if we\’re still alive!\” Another is quoted as saying: \”The traditional university model is the analogue of the print newspaper … 15 years max, you\’ve got the transformation.\” And yet another is quoted as: \”Universities face their biggest challenge in 800 years.\”

I would only add that universities and colleges typically don\’t like to think of themselves as \”businesses,\” but even nonprofit institutions have a \”business model\” in which revenue needs to match up to expenditures.  The higher education business model is going to be dramatically disrupted, and so far, we\’ve only seen the front edge of those changes.

The U.S. Census Bureau is out with the monthly trade data for September 2012. The trade deficit is down a bit since August, but not much changed over the last few years. Here\’s the monthly trade picture of imports and exports over the last couple of years. But what I want to focus on here is the possibility of raising U.S. exports as part of helping to regenerate economic growth.

The U.S. GDP was $14.6 trillion in 2010. By World Bank estimates, with the conversions between currencies done at the purchasing power parity exchange rates, the U.S GDP was essentially equal to the sum of the GDP of China ($10.1 trillion) and (India $4.2 trillion). In the two years since then, the sum of China\’s and India\’s economy surely exceeds the U.S. And looking ahead, the annual economic growth rates of China, India, and some other emerging market economies are likely to be a multiple of U.S. growth rates. In much of the last few decades, the U.S. consumer has been driving the world economy with buying and borrowing. But in the next few decades, the emerging economies like China, India, and others will be the drivers of world economic growth.

So how well-prepared is the U.S. economy to find its niche in the global supply chains that are of increasing importance in the world economy? The World Economic Forum offers an answer in \”The Global Enabling Trade Report 2012,\” published last spring. Chapter 1 of the report is called \”Reducing Supply Chain Barriers: The Enabling Trade Index 2012,\” by Robert Z. Lawrence, Sean Doherty, and Margareta Drzeniek Hanouz. They sum up the growing importance of global supply chains in this way: 

\”Traded commodities are increasingly composed of intermediate products. Reductions in transportation and communication costs and innovations in policies and management have allowed firms to operate global supply chains that benefit from differences in comparative advantage among nations, both through international intra-firm trade and through networks that link teams of producers located in different countries. Trade and foreign investment have become increasingly complementary activities. … Increasingly, countries specialize in tasks rather than products. Value is now added in many countries before particular goods and services reach their final destination, and the traditional notion of trade as production in one country and consumption in another is
increasingly inaccurate.\”

Their \”enabling trade\” index ranks countries in how their institutions and infrastructure support global trade, along a number of categories. Here\’s the list of the top 25 countries in their ranking: the U.S. economy ranked 19th in 2010, and dropped to 23rd in the 2012 rankings.

I\’m not especially bothered that the U.S. ranks behind national economies that are massively oriented to international trade, like Singapore and Hong Kong. But ranking behind other large high-income economies like Sweden, Canada, Germany, Japan and France is more troubling. Remember, countries that enable trade are the ones that will be prepared to participate in the main sources of future global economic growth. Here\’s how Lawrence, Doherty, and Hanouz sum up the U.S. situation.

\”Dropping four places, the United States continues its downward trend since the last edition and is ranked 23rd this year. The country’s performance has fallen in international comparison in almost all areas assessed by the Index, bar the efficiency of its border procedures and the availability of logistics services. The regulatory environment appears less conducive to business than in previous years, falling by 10 ranks from 22nd to 32nd. Concerns regarding the protection of property rights, undue influence on government and judicial decisions, and corruption are on the rise. And as in previous years, protection from the threat of terrorism burdens the business sector with very high cost (112th), and US exporters face some of the highest trade barriers abroad. Yet overall the United States continues to benefit from hassle-free import and export procedures (17th) and efficient customs clearance (14th), thanks to excellent customs services to business (3rd). The country also boasts excellent infrastructure, including ICTs, providing a strong basis for enabling trade within the country.\”

The U.S. economy, with its enormous domestic market, has traditionally not had to treat exports and foreign trade as essential to its own growth. But the global economy is changing, and more U.S. producers need to start looking longer and harder beyond their national borders.

Part of the lore of earlier economists as it was passed down to me around the campfire back in the Neolithic era  is the story of how Alban William Housego (Bill) Phillips, the originator of the famous 1956 paper that drew the \”Phillips curve\” tradeoff between unemployment and inflation, also built a hydraulic economic model: that is, a physical model of the economy in which flows of consumption, saving, investment and other economic forces were represented by liquid moving through tubes and pipes. What I hadn\’t known until more recently is that Irving Fisher also created an hydraulic model of the economy.

As a starting point for background on Bill Phillips and his famous 1956 Phillips curve paper, I can recommend the article by A.G. Sleeman called  \”Retrospectives: The Phillips Curve: A Rushed Job?\” which appeared in the Winter 2011 issue of my own Journal of Economic Perspectives. (Like all articles in JEP from the current issue back to the first issue in 1987, it is freely available on-line compliments of the American Economic Association.) The hydraulic computer is not the main focus of Sleeman\’s article, but he provides evidence that it was a major part of Phillips\’ career.

Apparently, Phillips completed his undergraduate degree at the London School of Economics in June 1949, specializing in sociology, and receiving only a \”Pass.\” From there, Sleeman writes (footnotes and references omitted:

\”In 1950, despite his poor degree, Phillips was appointed an Assistant Lecturer in the Department of Economics at LSE at the top of the pay scale, and simultaneously began his Ph.D. studies. The reason was that by 1949, Phillips had built the MONIAC: Monetary National Income Analogue Computer. (The name is a play on ENIAC, the Electronic Numerical Integrator and Computer, which had been announced in 1946 as the fifi rst general-purpose electronic computer.) MONIAC was a hydraulic machine, made of transparent plastic pipes and tanks fastened to a wooden board, about six feet high, four feet wide, and three feet deep. The MONIAC used colored water to represent the stocks and flows of an IS–LM style model and simulated how the model behaved as monetary and fiscal variables varied. The MONIAC brought Phillips to the attention of James Meade and, ultimately, to Lionel Robbins and other members of the LSE economics department. In 1950, Phillips published a paper on MONIAC in the August issue of Economica eight months after failing his Applied Economics and Economic History exams and passing Principles by a single point. In October 1951, the 36 year-old Phillips was promoted to Lecturer and tenured having published only one paper. Over the next two years Phillips completed his doctorate…\”

Phillips was born in New Zealand, and a December 2007 article in Reserve Bank of New Zealand Bulletin discusses the MONIAC. Here\’s a photo of Phillips standing beside the MONIAC at LSE, and a more recent photo of a MONIAC that the New Zealand central bank received from LSE and has restored to working order.

In the New Zealand central bank publication, Tim Ng and Matthew Wright describe the functioning of MONIAC this way: \”Separate water tanks represent households, business, government, exporting and importing sectors of the economy. Coloured water pumped around the system measures income, spending and GDP. The system is programmable and capable of solving nine simultaneous equations in response to any change of the parameters, to reach a new equilibrium. A plotter can record
changes in the trade balance, GDP and interest rates on paper. Simulation experiments with fiscal policy, monetary policy and exchange rates can be carried out. Although the MONIAC was conceived as a teaching tool, it is also capable of generating economic forecasts. Phillips himself
used the MONIAC as a teaching tool at the London School of Economics. Around 14 machines were built …\” For those with an insatiable need to know more about the MONIAC, I recommend this special December 2011 issue of Economia Politica: Journal of Analytical and Institutional Economics, which includes about a dozen articles about the lasting influence of Phillips and the MONIAC.  

But until recently, I hadn\’t known about that Irving Fisher had also built a hydraulic model of the economy as part of his doctoral dissertation back in 1891. I learned about it in the article by Robert W. Dimand and Rebeca Gomez Betancourt in the most recent issue of my own JEP. Their article is primarily focused, as the title notes on \”Irving Fisher’s Appreciation and Interest (1896) and the Fisher Relation.\” But in their capsule overview of Fisher\’s life, they write (citations and footnotes omitted):

\”His 1891 doctoral dissertation in mathematics and political economy (Yale’s first Ph.D. in political economy or economics), which was published as Mathematical Investigations in the Theory of Value and Prices (1892), brought general equilibrium analysis to North America; it was supervised jointly by the physicist and engineer J. Willard Gibb and the economist and sociologist William Graham Sumner. Paul Samuelson once described Fisher (1892) as the “greatest doctoral dissertation in economics ever written” … because Fisher invented general equilibrium analysis for himself before his last minute discovery of the writings of Léon Walras and Francis Ysidro Edgeworth. Fisher’s thesis went beyond these writings in one striking respect: influenced by Gibbs’s work in mechanics, Fisher not only imagined but actually built a hydraulic mechanism to simulate the determination of equilibrium prices and quantities—in effect, a hydraulic computer in the days before electronic computers …\”

Oddly enough, Fisher also wrote a paper that is an early harbinger of the Phillips curve literature. As Dimand and Betancourt write: \”In a series of articles, Fisher correlated distributed lags of price
level changes with economic activity and unemployment. His article “A Statistical Relationship between Unemployment and Price Level Changes” (1926 [1973]), little noticed when first published by the International Labour Office, attracted rather more attention when reprinted almost 50 years later in the Journal of Political Economy as “Lost and Found: I Discovered the Phillips Curve—Irving Fisher.”

I\’m not aware of any working models of Fisher\’s hydraulic computer, nor of any photographs of a working model. But  back in 2000, William C. Brainard and Herbert E. Scarf took on the task of investigating how the model worked in \”How to Compute Equilibrium Prices in 1891.\”  They reprint these sketches of Fisher\’s hydraulic computer from his dissertation. It apparently consisted of a series of cisterns, rods, floats, bellows, and tubes. It represents three consumers and three goods that they consume.

Apparently, Fisher used his hydraulic model of the economy as a teaching tool for 25 years. Brainerd and Scarf write (references omitted):

\”Fisher regarded his model as \”the physical analog of the ideal economic market,\” with the virtue that \”The elements which contribute to the determination of prices are represented each with its appropriate role and open to the scrutiny of the eye …\” providing a \”clear and analytical picture of the interdependence  of the  many elements in the causation of prices … \” Fisher also saw the machine as a way of demonstrating comparative static results, \”… to employ the mechanism as an instrument of investigation and by it, study some complicated variations which could scarcely be successfully followed without its aid. … 

\”Although we do not know what experiments Fisher actually ran with his machine, he does describe eight comparative static exercises. Some of these illustrate basic features of the system, for example that proportional increases in money incomes result in an equal proportional increase of each price, with no change in the allocation of goods. Another simple exercise discussed by Fisher examines whether proportional increases in the endowment of goods necessarily result in proportional decreases in prices, as was apparently, and incorrectly, believed by Mill. Some exercises illustrate less intuitive properties of exchange economies: increasing one individual\’s income may make some other individual better off, and also the possibility of `immiserating growth,\’ i.e. increasing an individuals endowment of a good may actually lower his welfare.\”

The idea of a hydraulic computer seems anachronistic in these days of electronic computation, but I can imagine that an illustrative teaching tool, watching flows of liquid rebalance might be at least as useful as looking at a professor sketching a supply and demand diagram. In addition, the notion of the economy as a hydraulic set of forces still has considerable rhetorical power. We talk about \”liquidity\” and \”bubbles.\” The Federal Reserve publishes \”Flow of Funds\” accounts for the U.S. economy. When economists talk about the financial crisis of 2008 and 2009, they sometime talk in terms of financial \”plumbing.\” For example, here\’s Darrel Duffie:

\”And there has been a lot of progress made, but I do feel that we’re looking at years of work to improve the plumbing, the infrastructure. And what I mean by that are institutional features of how our financial markets work that can’t be adjusted in the short run by discretionary behavior. They’re just there or they’re not. It’s a pipe that exists or it’s a pipe that’s not there. And if those pipes are too small or too fragile and therefore break, the ability of the financial system to serve its function in the macroeconomy … is broken. If not well designed, the plumbing can get broken in any kind of financial crisis if the shocks are big enough. It doesn’t matter if it’s a subprime mortgage crisis or a eurozone sovereign debt crisis. If you get a big pulse of risk that has to go through the financial system and it can’t make it through one of these pipes or valves without breaking it, then the financial system will no longer function as it’s supposed to and we’ll have recession or possibly worse.\”

I find myself wondering about what an hydraulic model of an economy would look like if it also included bubbles, runs on financial institutions, credit crunches–along with tubes that could break. Sounds messy, and potentially quite interesting.

The Congressional Budget Office has just published a report called \”Choices for Deficit Reduction.\” To me, the bottom line is that coming to grips with the U.S. fiscal situation in the medium run is going to require going outside everyone\’s current comfort zone.

To set the stage, here are the CBO projections for the debt/GDP ratio in the next couple of decades. As I\’ve discussed before on this blog (for example, here), the CBO is required by law to calculate a \”baseline scenario\” which projects the debt under current law. The difficulty with this approach is that current law can incorporate all kinds of future spending cuts or tax increases that aren\’t actually going to happen when the time comes. Thus, the CBO also calculates an \”alternative fiscal scenario,\” which is based on four assumptions:

• \”That all expiring tax provisions (other than the recent reduction in the payroll tax for Social Security), including tax provisions that expired at the end of December 2011, are extended;
• That the parameters of the alternative minimum tax (AMT) are indexed to increase with inflation after 2011 (starting from the 2011 exemption amount);
• That Medicare’s payment rates for physicians’ services are held constant at their current level; and 
• That provisions of the Budget Control Act of 2011that established automatic enforcement procedures designed to reduce discretionary and mandatory spending beginning in January 2013 do not go into effect, although the law’s original caps on discretionary appropriations remain in place.\”

The \”alternative fiscal scenario\” provides a useful starting point, because you can then look at how changing each of these four assumptions, along with many other policy changes, would affect the debt/GDP over time.Under the alternative scenario, the debt/GDP is headed for the danger zone of about 90-100% debt/GDP by the early 2020s, and then is headed for unimaginably high levels after that.  (For discussions of why that 90-100% ratio is likely to be important, see earlier posts here, here, and here.)

As one way of getting a handle on what needs to be done, the CBO looks at a variety of possible spending and tax policies, and how they would affect the budget deficit that in the alternative fiscal scenario would be about $1 trillion in 2020. Thus, steps that reduce the projected 2020 deficit by $1 trillion would balance the budget, and get the debt/GDP ratio on a declining path. Steps that reduce the projected 2020 deficit by $500 billion would keep the debt/GDP ratio in 2020 about the same as it is now–but the debt/GDP ratio would start rising after that point. An intermediate set of policies that reduce the 2020 deficit by $750 billion would put the long-term trend of the debt/GDP ratio on a slightly declining path–more-or-less what the baseline scenario looks like.

So what do the possible policy options look like? They come in three tables: possibilities for reducing mandatory spending, possibilities for reducing discretionary spending, and possibilities for increasing taxes. You\’ll notice that many of the recommendations come with various footnotes and caveats, which in turn require heading for the actual report. Some of the recommendations overlap in various ways (like different methods of altering Social Security or Medicare), and so you can\’t just add up all the choices. But for a quick sense of the issue, just glance at the right-hand numbers showing the total projected change in the deficit. If you take the intermediate goal of cutting the projected 2020 deficit by $750 billion, most people will very quickly run out of easily palatable options.

For example, repealing the expansion of health insurance coverage and the \”individual mandate\” to buy health insurance from the Affordable Care Act would reduce the 2020 deficit by about $190 billion, which is real money, but not nearly enough (and would leave tens of millions of Americans again without health insurance). Or letting the the tax cuts enacted in 2001, 2003, and 2009 expire only for couples filing joint tax returns with income over $250,000 per year and for single taxpayers with income over $200,000, along with indexing the alternative minimum tax (AMT) for inflation, reduced the 2020 deficit by $110 billion, which is real money, but not nearly enough to do what is needed. So even if Republicans and Democrats would compromise on eliminating Obama\’s health care plan in exchange for eliminating the Bush tax cuts for those above $200,000 or $250,000 per year, they would have less than half of the $750 billion deficit reduction. To put it another way, Americans and U.S. economy are more drunk on deficit spending, and withdrawal is going to be more painful than most people realize.

Here are the three tables of options:

Douglas Clement has an insightful interview with Janet Currie in the September 2012 issue of The Region magazine published by the Federal Reserve Bank of Minneapolis.  As Currie says near the start of the interview: “Labor economists think a lot about human capital and investments in it. Traditionally, that’s something to do with education, … [b]ut I’m interested in health as human capital as well, and understanding how health and education intersect. … “It is a broad concept, human capital … Not all these different boxes, but an integrated whole.\” The interview makes a number of interesting points about an array of subjects, including how financial incentives affect the practice of medicine ( no matter what doctors say!), early childhood education, and women in the economics profession.

Here, I\’ll focus on one topic: the fetal origins of inequality. Here\’s the question from Clement, and part of Currie\’s answer:

Region: Could you briefly review the fetal origins hypothesis and how economists have expanded its reach—to test scores, education and income as well as health?

Currie: I think the phrase itself was coined by David Barker, a physician who was interested in whether there was a biological mechanism such that if the fetus was starved in utero it would be more likely to be obese or more likely to have heart disease or diabetes, things related to that in later life.
… An infant programmed in this way would then be more likely to gain a lot of weight later on and to have diseases related to obesity…. I believe Thalidomide was the first thing that really shocked people and showed that if you give drugs to the woman, that it could have an effect on the fetus. People were also working on the Dutch “Hunger Winter” prior to Barker, looking into whether being literally starved in utero had long-term effects.

So economists have taken that idea and run with it. Economic studies are examining a wide range of things that might affect fetal health and asking whether they have long-term consequences. I think there’s pretty broad acceptance now of the idea that all kinds of things that happen when people are in utero seem to have a long-term effect.

One of the things I talked about in my Ely lecture was what mechanism might underlie the long term effects, and I raised the idea of “epigenetic” changes as one possibility. The way I like to think about that is you have the gene, which only changes very slowly when you have mutations. But then kind of on top of the gene you have the epigenome, which determines which parts of the gene are expressed. And that can change within one generation. There are animal experiments that do things like change the diet of guinea pigs and all the baby guinea pigs come out a different color. It can be pretty dramatic. …   The idea is that the fetal period might be particularly important because these epigenetic switches are being set one way or another. And then once they’re set, it’s more difficult to change them later on.

I think we haven’t really been able to look at all of the implications of that given the limitations of the data. We don’t have very much data where we can follow people from, say, in utero to some later period. But, that’s where the frontier is, trying to do that kind of research and make those linkages….

I think a really interesting thing about the fetal origins hypothesis for public policy is that if it’s really important what happens to the fetus, and some people think that maybe the first trimester is the most important or the most vulnerable period, then you’re talking about women who might not even know that they’re pregnant. It really means you should be targeting a whole different population than, say, 15 years ago, when we thought, oh, we need to be targeting preschool kids instead of kids once they reach school age. Now we’re kind of pushing it back. Then it was, “We need to be playing Mozart to infants.” Now the implication is that we’ve got to reach these mothers before they even get pregnant if we really want to improve conditions.

Epigenetics implies that it does not make sense to talk about nature versus nurture. If nature is the gene and nurture is the thing that sets the switches, then the outcome depends on both of those things. So you can’t really talk about nature or nurture in most situations. It has to be some combination of both. …

One thing that is interesting—and I’m starting to do a little bit of work like this myself—is thinking about children in developing countries. Things we’re looking at here in the United States, like the effects of in utero exposure to pollution on child health and economic outcomes, involve problems that are much worse in developing countries. So if we can find an effect here … for instance, my E-ZPass paper suggested that the incidence of low birth weight was 8 percent higher for pregnant women who are subjected to large amounts of auto exhaust because they live near highway toll plazas. If that is true here, then what must be the effect in Beijing? It must be even bigger than that.

Currie, along with Douglas Almond wrote on this topic in the Summer 2011 issue of my own Journal of Economic Perspectives in \”Killing Me Softly: The Fetal Origins Hypothesis\” (25(3): 153-72). That article, like all articles in JEP back to the first issue in 1987, is freely available to all courtesy of the American Economic Association. Another useful starting point to this literature is Currie\’s Ely lecture on this topic (mentioned in passing in her answer above): \”Inequality at Birth: Some Causes and Consequences.\” American Economic Review, 101(3): 1-22. The AER is not freely available on-line, but many in academia will have on-line access through AEA memberships or library subscriptions.

 For yet another recent angle, there\’s an article in a recent Economist magazine on \”Epigenetics and Health: Grandma\’s curse.\” The big question is whether an acquired characteristic–like, say, asthma that is caused by heavy smoking–can be inherited. A plain-vanilla theory of inheritance says this isn\’t possible, because smoking is bad for you, but it doesn\’t alter your genes. However, studies on pregnant rats apparently show that if a first generation of rats is dosed with nicotine, which leads to asthma, then the first generation of offspring also has a propensity to asthma. That result is unsurprising, because it\’s just the fetal origins hypothesis in action. But apparently, the next generation of rats after that also has a greater propensity to asthma, although that generation was never expose to nicotine directly. The epigenetic explanation is that nicotine doesn\’t change genes, but it can alter the \”switches\” that determine what characteristics are expressed by those genes, and those different \”switches\” can be to some extent inherited. As the article writes: [T]hose epigenetic changes that are inherited seem to be subsequently reversible. But the idea that acquired characteristics can be inherited at all is still an important and novel one …\”

The Fall 2012 issue of my own Journal of Economic Perspectives is now freely available on-line. Actually, all issues of JEP back to the first issue in 1987 are freely available on-line, compliments of the American Economic Association.

The issue starts with a three-paper symposium on the issue of  \”contingent valuation,\” which is whether it makes sense to use survey techniques to estimate the costs of events like the Exxon Valdez oil spill in 1989 or the BP oil spill in 2010. The symposium has an overview paper laying out the issues, followed by pro and con viewpoints. Next comes a five-paper symposium on various aspects of China\’s economy: labor markets, macroeconomic imbalances, and perspectives on patterns of long-term growth. The final three papers are about the Clark medal awarded to Amy Finkelstein, about Irving Fisher\’s famous 1896 paper, and a \”Recommendations for Further Reading\” that I contribute to each issue.

Symposium on Contingent Valuation

\”From Exxon to BP: Has Some Number Become Better Than No Number?\” by Catherine L. Kling, Daniel J. Phaneuf and Jinhua Zhao

On March 23, 1989, the Exxon Valdez ran aground in Alaska\’s Prince William Sound and released over 250,000 barrels of crude oil, resulting in 1300 miles of oiled shoreline. The Exxon spill ignited a debate about the appropriate compensation for damages suffered, and among economists, a debate concerning the adequacy of methods to value public goods, particularly when the good in question has limited direct use, such as the pristine natural environment of the spill region. The efficacy of stated preference methods generally, and contingent valuation in particular, is no mere academic debate. Billions of dollars are at stake. An influential symposium appearing in this journal in 1994 provided arguments for and against the credibility of these methods, and an extensive research program published in academic journals has continued to this day. This paper assesses what occurred in this academic literature between the Exxon spill and the BP disaster. We will rely on theoretical developments, neoclassical and behavioral paradigms, empirical and experimental evidence, and a clearer elucidation of validity criteria to provide a framework for readers to ponder the question of the validity of contingent valuation and, more generally, stated preference methods.